Updating my Income Fund asset allocation

An investment portfolio can be like soap – the more you handle it, the smaller it gets. Be that as it may, I adjusted my target Income Fund asset allocation this month and sold some investments. Read on for the details.

The original asset allocation

Here’s the Fund’s actual asset allocation as it appeared at the end of November.

I was under-allocated on the two stock funds, and over-allocated on pretty much everything else for a total of 76:24 Stocks to Bonds.

The Income Fund is all held in Taxable accounts so most rebalancing that I do is only with new capital towards under-allocated holdings. This avoids triggering large capital gains. Over the course of the year, allocations moved by about 4%, since a lot of new capital is needed to move the needle.

Why change it?

I was originally contemplating to go 100% in Stocks and eliminate the Bond Funds entirely. A lot of this thinking was driven by their higher tax inefficiency. Bond fund distributions are taxed at my marginal 28% tax rate and not the 15% of qualified dividends. But the yields are higher to start with so it ends up being fairly close on a tax adjusted basis (a little in favor of bonds).

Selling out of the bonds would also reduce my forward dividend income significantly since the replacement stocks wouldn’t cover the bond yield.

But that’s not much of a basis on which to move to 100% Stocks. I’m more interested in sustained income and not at all concerned about volatility in terms of price movement. So although Bond prices are set to fall further next year due to higher interest rates, they do provide reasonable income even when adjusted for taxes.

Enter the Emergency Fund

In a way, this is a logical step but the mental accounting of having a dedicated and separate Emergency Fund had always stopped me. Yet my Income Fund is really a great big hedge against losing my job since its purpose is to make me Financially Independent. Could this be a case of killing two birds with one stone? (*)

I also avoided the Total Bond Fund (VBTLX) as it will cause complications with any Tax Loss Harvesting I might want to take advantage of. The Government Bond funds are all Admiral class so have a higher purchase limit and lower ER.

Since this is in a Taxable account I should mention that Vanguard also has some tax managed bond funds. These invest in municipal bonds whose interest is not taxed at a Federal and/or State level. They can make sense at higher tax brackets. I’m not convinced that their benefits (lower taxes) overcome their negatives (lower yield, possible exposure to AMT) for my situation.

Making a choice

The volatility of the funds is linked to their duration. In the case of the intermediate funds, the fund duration is five to ten years. The rule of thumb is that for a 1% increase in interest rates, there could be a 5 to 10% drop in the price.

The following chart shows the Price Return of the four bond funds above over the last five years to give an example of their volatility. The Intermediate duration funds behave similarly as do the two Short-Term funds. Over that time period, the intermediate funds lost up to 10% in their biggest drawdown with VBIIX being most volatile in 2013.

I’m okay with taking some risk, so I decided on using VBIIX as the basis for my new Emergency Fund allocation. Since it’s linked to a percentage of the fund, it’ll end up being a larger total amount over the long-term than the preset dollar target I used in my EF before. It’ll also contribute a little to current income, more so than a high-yield savings account.

New Target Allocation

The following table shows the new target allocations and the actual allocation as of 20-December.

This results in a 60 (US Stock) : 20 (International Stock) : 20 (US Bonds) asset allocation. I decided to reduce exposure to International as little to make room for the new Emergency reserve holding. Overall stock allocation decreased 5% and bonds increased 5%.

In making this change, I sold my prior holdings in VWESX (Long-Term Investment Grade) and converted the proceeds into VHDYX and VIHAX. I also sold a smaller amount of VWEAX at a loss and converted that into VBIIX. This reduced the allocation of VWEAX down 2% from before.

I’ll be adding to VBIIX monthly for the next ten months as I draw down my existing Emergency Fund cash. This is currently held in a money market fund.

In the short-term there will be a small drop ($15) in monthly income due to lower monthly bond distributions. However the extra new money being added to the Fund over the coming year should make up for it.

Summary

I think that bonds have value in an Income-oriented portfolio such as mine, so I’m happy with the higher asset allocation of 80:20. The choice of higher-quality bonds allows some capital to be withdrawn from the fund at a lower risk if needed. Yet it still contributes to monthly income. The different asset class provides more flexibility for withdrawing capital and avoiding Capital Gains.

The new target allocation is closer to my current allocation, so this should be easier to meet going forward. In the long-term as the Income Fund grows, I may reduce the Intermediate-Term allocation percentage but I will maintain a 20% exposure to Bonds.

(*) No birds were harmed in the writing of this article. Don’t throw stones at birds, especially seagulls. Or you may, like Gregory in my 3rd Grade at school, actually hit one and knock it unconscious. And then become the class pariah for a couple of weeks.

Quote of the Day

Tell me and I forget. Teach me and I remember. Involve me and I learn.

Post navigation

Disclaimer

I am not an investment, finance or tax professional. All content posted on this blog represents my opinion and views and should never be considered professional advice. You should do your own research and consult with a professional financial advisor before making any investment decisions. Investments are not FDIC insured and may lose value.
Legal Disclaimer

Privacy

This blog does not collect any personal information except that which is freely shared publicly through comments or other means. This information is not sold or disclosed to other parties for any reasons. I will never sell personal information of any visitors for any purpose.
Privacy